China and Emerging Markets: Riding Wild Horses

One month ago, I discussed some major risks to a slight upturn in the global economic scenario for 2014. Among those risks, concerns with the growth slowdown and challenges with shadow banking in China have already come to the fore as the Chinese Year of the Horse approached its inauguration last Friday.

Higher perceived risks about China have added another potential vulnerability, as witnessed by a new round of capital flows out from emerging markets in the last few weeks, resembling the one of last summer. While US 10-year Treasury yields have descended a bit since December, despite the beginning of the actual Fed tapering, news on China’s industrial production softness have sped up the on-going steady course of reduction of exposure of global portfolios to emerging markets in general, in favor of advanced economies. Idiosyncratic political and/or economic events also mattered in particular cases (Turkey, Ukraine, South Africa, and Argentina) but the fact that countries with liquid markets and less fluid conditions – like Mexico, Poland, and Malaysia – also suffered some asset sell-off indicates a much broader scope is at play.

How significant are the potential global spillovers from China’s economic growth slowdown? Why has the latest news particularly affected emerging markets? Last Friday, JPMorgan’s “Global Data Watch” offered some clues. Their research estimates that a 1 percentage point fall in Chinese GDP growth rates tends to have something like a total 0.46 p.p. negative impact on global growth, over four quarters, with effects through oil prices embedded. However, while this reflects a 0.21 p.p. drop in the GDP growth of advanced economies, the corresponding figure for the other emerging markets as a whole is 0.73 p.p. Commodity-dependent countries would be especially hard-hit, as the others may count on some revival of imports from advanced economies.

The world has kept close watch on the ongoing downward adjustment of China’s shadow banking system – credit intermediation involving entities and activities outside the regular banking system – with the near-default of a large trust product during the last few weeks being part of the worrisome news coming from the country. Not because of financial linkages with the rest of the world, as foreign ownership of entities is low and domestic sources and destinations of flows are overwhelmingly predominant, but for the risks that a disorderly unwinding might deepen the already expected growth slowdown.

The Chinese shadow banking system did not look very large compared to other countries (including other emerging markets) in the recent past – see Ghosh et al (2012). However, not only has the expansion of the shadow banking system been extraordinary over the last three years, but also the private non-financial sector debt as a percentage of GDP, which has risen dramatically since 2009. China’s economic policy reaction to the post-2008 fears of a global crash led to some laxity with respect to the rapid expansion of shadow-banking channels of finance of investments and real-estate spending through special purpose vehicles, including those owned by subnational governments. As it often happens with sudden and intense spurts of credit ease, part of the pyramid of newly created assets and liabilities has “pyramids” or “white elephants” as their real-side counterpart.

Chinese authorities must therefore tread cautiously. While maintaining the pressure to correct balance sheets, by taking a hard stance on the side of official refinance backstops, they shall try to avoid panicky effects of occasional bankruptcies by ring-fencing some systemically relevant financial entities. How well this is done will bear consequences on Chinese current GDP growth rates, their impact on emerging markets in general and, therefore, on the risk that a panicky unwinding of exposure to emerging markets might provoke a strong deceleration of the latter, engendering in turn a negative feedback loop to advanced economies. The 2014 baseline for the global economy still appears to be trending upwards, but the Year of the Horse may be jumpy.